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Market Update – Winter is Coming

Market Update – June 2017 – “Winter Is Coming”    

By: Rand Baughman CFP®

It has been another good start to the year in the markets. All asset classes have seen positive returns. The best performing asset class, in both equity and fixed income, has been Emerging Markets. The post-election rally in US Small Cap has tapered off in 2017.

Even though the markets have been performing well, I believe we are approaching the latter stages of the recovery for a couple of reasons:

  1. Law of Large Numbers – In probability and statistics, the law of large numbers states that as a sample size grows, its mean gets closer to the average of the whole population. In the past 100 years, there have been 24 years the markets have had negative returns. This comes out to an average of once every 4.17 years. We have experienced positive returns since 2009, so we are due.
  1. Current Valuations – One of the basic premises of investing is buying an asset that will appreciate over time. We use valuations to help us gauge whether an investment is under-, fairly-, or over-valued. The valuations are done by comparing an investment’s current price (price they are currently trading) to their fair market value (the rational and unbiased estimate of the potential market price of an asset). If the goal of the investment is capital appreciation, then we want to buy an investment that it either under- or fairly-valued. Buying an investment that is over-valued means we are paying a premium for this investment, so the potential for capital appreciation is reduced.

Below is a graph that shows the current valuations among the major countries. Unlike previous quarters, when there was value in international developed and emerging markets, valuations around the world are currently overvalued.

  1. Key Recovery Drivers are Slowing – When we look at the drivers of the recent economic recovery, most economic analysts focus on macro factors such as interest rates and fiscal stimulus (I’m guilty as charged). But there were also micro factors such as shifting industry dynamics and new technologies that helped drive the recovery. Autos, airliners and the energy sector led the way. When these sectors started to decline, healthcare and restaurants helped fill the void. Now healthcare (Affordable Care Act transition nearing completion) and restaurant spending (slower employment growth, cheaper groceries) are showing signs of slowing.

The title of this article – “Winter is Coming” – is a phrase often used in the hit TV show ‘Game of Thrones’. Ned Stark, the patriarch of the Stark family, coined the phrase to emphasize that even though there is currently peace, war will be coming. The purpose of this article is not to scare anyone; it is to prepare us for a potential downturn.

So how do we prepare for a potential downturn?

  1. Understanding the History – Below is a chart that shows the history of the market through past expansions, downturns and recoveries. There have been some pretty significant economic events that have happened in the past – The Great Depression, Black Monday in 1987, the Dotcom Bubble and the recent Financial Crisis. These events were all unprecedented and “the first of its kind” but each time the market recovered.

  1. Time Horizon – What is the time horizon for your investment? Is it short- or long-term? If the time horizon is short-term, then we will adjust your allocation to make sure it is aligned efficiently with your goals. If the time horizon is long-term, then a little volatility is a buying opportunity to take advantage of! The last thing we want to do is try to time the market by jumping in and out. As you can see from the chart above, the market has returned 86.7% since the expansion started in March 2012. Based on past expansions, there could still be room for growth in this cycle.

Let’s be honest, we have been saying a correction is coming for about four years now. You probably would not be too pleased with us if we had given advice to hold money out of the market four years ago. Therefore, timing the market is not a viable option. Nobody has a crystal ball, and nobody can predict the future.

  1. Portfolio Testing – We will periodically ask expert third parties to audit our portfolios. We used JP Morgan Asset Management earlier this year. We thought this would be a good idea because they are a third party that could provide an objective view. We compared our portfolios to a couple of benchmarks – S&P 500, Barclays Aggregate Bond and a diversified portfolio constructed with each asset classes index. We were most interested in seeing how the portfolios performed under past market downturns. The results are in the chart below:

We expected the portfolios to have less of a drop than the S&P 500, because a diversified portfolio should have less risk than one asset class. We were most pleased that our portfolios performed better than the benchmark diversified portfolio. This data confirmed that we have diversified our portfolios and positioned them well for any potential downturn.

  1. Having a Plan – This is, hands down, the most important thing we can do to prepare for “winter”. The plan is the roadmap that guides us through the ups and downs of life to allow us to reach our goals. Rates of return can vary greatly; our main objective is to make sure you reach your goals.

In closing, we are grateful for the opportunity to work with you and we do not take the opportunity lightly. We believe transparent communication on the shifting markets is a key component in maintaining our relationship. As the year continues, expect to hear more from us on trends, expectations and planning opportunities. In the meantime, call if you have any questions or if you want to grab a cup of hot chocolate or go winter glove shopping.

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